U.S. bonds still best sovereign-debt bet

After failing to predict this year's Treasury rally, Wall Street's biggest bond traders are sticking to forecasts that government bonds will fall as the economy recovers and concerns over a European debt crisis recede. Yields on 10-year Treasury notes will rise to 3.5 percent by the end of 2011 from this year's low of 2.84 percent on June 27, according to a Bloomberg News survey of the 20 bond dealers that serve as counterparties to the Federal Reserve in its open market transactions. The higher rate is still only half the 7 percent average on the securities over the past four decades. While Speaker of the House John Boehner says the country is broke, and the Federal Reserve has flooded the financial system with dollars, U.S. debt has returned 2.09 percent since December, including reinvested interest, almost triple the 0.7 percent for government bonds worldwide, according to Bank of America Merrill Lynch index data. Yields near record lows have frustrated fixed-income investors looking for more return. “People make comments that rates can't stay this low because there is sticker shock when they look how far we've come,” said Jeffrey Schoenfeld, a partner and chief investment officer in New York at Brown Brothers Harriman & Co., which manages $33 billion in assets. “But we are in a moderate growth recovery with little evidence of inflation pressure and the Fed in no hurry to change its stance. The path of least resistance is very low” rates for a long time, he said. Top Performers Treasuries fell the most in almost two years last week, pushing 10-year yields to the highest level since May as Greek lawmakers approved budget cuts needed for a second bailout to avoid default. Yields on 10-year notes rose 32 basis points, or 0.32 percentage point, to 3.19 percent, according to Bloomberg Bond Trader prices. The 3.125 percent securities maturing in May 2021 dropped 2 23/32, or $27.19 per $1,000 face amount, to 99 16/32. The increase was the biggest since yields climbed 37 basis points during the five days ended Aug. 7, 2009. Ten-year yields fell three basis points to 3.16 percent as of 10 a.m. today in London. Treasuries outperformed all Group of Seven debt in the first half. The U.K returned 1.78 percent, Canada 1.79 percent, Italy 1.68 percent and Japan 0.6 percent. German and French debt left investors with losses. Corporate Debt Corporate debt has done even better, gaining 3.2 percent this year as companies sold $1.9 trillion of bonds, a 24 percent increase from the same period of 2010. The Standard & Poor's 500 Index of stocks has risen 7.57 percent this year. The S&P GSCI index of 24 commodities has slid 13 percent from the high this year reached on April 8. Companies and consumers are starting to get relief from energy costs, as crude oil has fallen 17 percent from this year's peak of $114.83 a barrel on May 2. Inflation expectations are rising. Yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.41 percentage point inflation rate during the life of the debt, higher than the five-year average of 2.07 percent and up from 1.5 percentage points in August 2010 when Fed Chairman Ben S. Bernanke first indicated the central bank might begin the second round of asset purchases, or quantitative easing, known as QE2. After buying $1.7 trillion in securities through last year, increasing the amount of money in circulation to prevent deflation, the central bank started a $600 billion program that ended last week. QE2 also succeeded in driving investors into riskier assets. Since its start, the S&P 500 Index (SPX) has risen 13 percent. Negative Position U.S. debt outstanding has grown to $9.26 trillion in marketable Treasuries from $4.34 billion in mid-2007, before the recession and collapse of Lehman Brothers Holdings Inc. Treasuries returned 5.88 percent last year after losing 3.71 percent in 2009. Primary dealers are betting that the second half of the year will be different with the U.S economy forecast to expand, the Fed winding down debt purchases and officials in Europe compromising to prevent Greece defaulting on its debt. The 20 firms have a negative $44.5 billion position in Treasury notes and bonds, compared with the negative $11 billion average of the last three years, indicating they expect prices will fall. Revenue Outlook Revenue of S&P 500 companies will climb 10 percent this year, twice the rate of 2010, according to data from analysts compiled by Bloomberg. That will help increase 2011 profit even as companies run out of opportunities to reduce costs by firing workers or closing factories. Business activity in the U.S. expanded at a faster pace in June as orders and production picked up, signaling manufacturing will keep driving growth in the world's largest economy. The Institute for Supply Management-Chicago Inc. said last week its business barometer climbed to 61.1 in June from 56.6 in May. Economists called for the index to drop to 54, according to the median forecast in a Bloomberg News survey. Figures greater than 50 signal expansion. Two years after the 18-month recession ended in June 2009, the expansion is “continuing at a moderate pace, though somewhat more slowly” than anticipated, Fed policy makers said on June 22. The officials said the economy will grow 2.7 percent to 2.9 percent this year, down from forecasts ranging from 3.1 percent to 3.3 percent in April. Consumer spending stagnated in May as payrolls rose at the slowest pace in eight months, and the unemployment rate climbed to 9.1 percent from 9 percent in April, according to Commerce and Labor Department data. ‘Sputtering, Not Stalling' The U.S. economy is “sputtering, but not stalling,” Goldman Sachs Group Inc. said in a June 23 research note to clients. The “recent disappointment in first-half growth is not yet long enough or deep enough to tilt the balance of risks toward recession,” Andrew Tilton, an economist at Goldman Sachs in New York, wrote. The Fed will remain the biggest buyer of Treasuries as it uses its $2.86 trillion balance sheet to spur the economy by purchasing U.S. government debt with proceeds from the maturing securities it owns. That could mean as much as $300 billion of government debt over the next 12 months without adding money to the financial system. ‘Hell Bent' “We've still got a Fed hell bent on increasing inflation expectations, negative real returns and risk assets continuing to outperform,” said David Zervos, the global head of fixed- income strategy in New York at Jeffries Group Inc., the most bearish of the 20 primary dealers, expecting the yield to hit 4.25 percent by year end. If he's right, 10-year note investors will lose 6.8 percent, according to data compiled by Bloomberg. “The recovery and reflation trade is still underway and that will send rates higher,” he said. The Greek Parliament last week approved Prime Minister George Papandreou's 78 billion-euro ($112 billion) package of tax increases and asset sales that was a condition of receiving further European Union aid and staving off default. “At these levels we are really pricing in complete disaster and that's just not what we are seeing,” said Michael Cloherty, the head of U.S. rates strategy for fixed income and currencies at the primary dealer Royal Bank of Canada in New York. Rates May Rise RBC says 10-year rates may rise to 3.5 percent by the end of the year after the U.S. economy grew 1.98 percent in the first quarter, the seventh straight period of economic expansion. “We are expecting weak growth, but it's still growth that should slowly chip away at the slack in the economy.” The standoff between Obama's administration and Congress over increasing the government's borrowing limit may lead to higher yields, Zervos said, as Moody's Investors Service and Standard & Poor's said they may consider cutting the nation's AAA credit rating unless progress is made next month. Vice President Joseph R. Biden's bi-partisan deficit- reduction group has been meeting since May 5 to reach a compromise that would trim long-term deficits by as much as $4 trillion and clear the way for a vote in Congress to raise the $14.29 trillion debt ceiling. Treasury Secretary Timothy F. Geithner has said the U.S. risks defaulting if the limit isn't increased by Aug. 2. Boehner, an Ohio Republican, said last week the House wouldn't approve any deal that includes tax increases. Even without a default, “rates are overvalued and will rise as the economic recovery continues, albeit slowly,” said Mark MacQueen, a partner and portfolio manager at Austin, Texas- based Sage Advisory Services, which oversees $9.5 billion. “Despite headwinds, the economic recovery will continue into the end of the year.” --Bloomberg News--